Let's Get Real: Yields Fall Short of Inflation

By

Randall W. Forsyth

August 18, 2011

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Who would have thought that a bond that yields zero would be a good deal? Only because professional investors are willing to accept significantly less, grandma and grandpa can get a decent deal for their grandkids. Therein lies a tale.

The Treasury will auction securities Thursday that will carry a negative yield, in real terms at least. After inflation, investors are willingly accepting less than zero return for the certainty that they will get their money back with the assurance of the full faith and credit of the U.S. government, Standard & Poor's notwithstanding.

To market professionals, this is but a curiosity. But for the rest of us, a negative real yield ought to raise questions. Why would investors suffer a guaranteed negative real return? Do they expect inflation to rise meaningfully in the years ahead? Or is this merely a technical glitch resulting from low nominal yields and the way the consumer price index is constructed? Whatever the case, small savers can actually do better than the big money in putting their savings in an instrument that at least keeps up with inflation -- with the backing of Uncle Sam.

Whatever the case, bidders at Thursday's auction of Treasury Inflation Protected Securities, or TIPS, maturing in five years are likely to demand at a yield of around minus 1%. That is a real yield, that is, what you get after inflation.

With TIPS, the value of the security is adjusted upwards according to the CPI. And not some phony-baloney "core" measure that excludes food and energy, two necessities to normal people but ignored by economists. And also the rich SOB who just flew over my house in a helicopter on his way to the Hamptons, blissfully unaware of the energy cost to himself or the annoyance to everyone else.

Accepting a negative real yield isn't irrational when one looks at the numbers. The five-year garden-variety Treasury yields 0.91% while the five-year TIPS yields negative 0.87%. The nominal rate minus real interest rate equals the anticipated inflation rate. Thus, rearranging the sums shows the TIPS market is forecasting the CPI will rise 1.78% per annum in the next five years. The insurance from rising prices -- and from capital loss -- is valuable enough that an investor will pay for it in a negative real yield.

Moving further out the yield curve, the benchmark 10-year note yields 2.21% while the 10-year TIP yields about zero (negative 0.02% to be exact.) Thus, the real yield on the Treasury 10-year note is virtually nil; all the interest return compensates for inflation. Investors are willing to lend Uncle Sam money at a real return of nothing for a decade.

That says a lot about the investment opportunities out there. One can buy top-grade, tax-free municipal bonds at yields equal to or exceeding those of Treasuries. One can buy an array of stocks in the S&P 500 with yields that exceed the benchmark 10-year Treasury note but also having potential to increase earnings and dividends.

Indeed, there is an array of investments that actually benefit from the Federal Reserve's strategy of holding short-term interest rates near zero. I wrote about a number of them in the print version of Barron's this week. ("Low Rates, Big Opportunities", Aug. 15.)

But there's also a humble investment for hoi polloi that compares favorably with these clever buys. That would be I Savings Bonds. The biggest problem with them is that you can't buy them by the truckloads. The Treasury's Web site (www.ustreasury.gov) shows that there is a $5,000 cap on purchases.

I Savings Bonds are unlike traditional savings bonds that have been given to kids forever. I bonds are issued at face value and are adjusted according to the CPI. A decade ago, I bonds issued then paid 4% over the CPI. A $1,000 I bond purchased then is worth over $1,800, with the accrual not taxed until the bond is redeemed.

These days, I Savings Bonds yield zero before adjustment for inflation. That is valuable, as evidenced by the markets' willingness to accept a negative yield on the TIPS on the auction block Thursday. Moreover, it's better than what the average saver can do without taking on some risk.

Nil is still more than negative real yields the institutional market is getting on Treasury securities. And negative real yields show the parlous state of the economy and markets.

Let's Get Real: Yields Fall Short of Inflation

Who would have thought that a bond that yields zero would be a good deal? Only because professional investors are willing to accept significantly less, grandma and grandpa can get a decent deal for their grandkids.

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